In recent years, agile methods have been widely adopted throughout the software industry. They also have become the de-facto standard when it comes to creating new products and services, either within established companies or as startups.

While there is a lot of literature about agile development approaches (e.g., Scrum, Kanban; LeSS, SAFe), developing business models (e.g., Business Model Generation), user experience approaches and methods (e.g., Lean UX), there are few little efforts towards how to come up with prices for newly created products and services, and how to come up with convincing sales argumentations for the latter.

This important aspect is referred to as pricing, and there are various methods for how to define prices for new products and services.

Cost-oriented pricing

Traditionally, cost-oriented pricing approaches are most widely applied by marketers and pricing managers to define a target price for a product or service.

The approach works by identifying all cost related to producing a unit of the product and service and then adding a mark-up to achieve a specific gross-margin.

This approach works well and is relatively straight forward as the (internal) development cost can easily be determined.

Also, customers especially in transparent B2B markets favor this approach as it allows them to control how much gross-margin their suppliers can make.

Break-even analysis

The break even price is the price that will produce enough revenue to cover all research & development as well as production costs for a given product.

The costs can be separated into fixed costs and variable costs. Fixed costs, for example, comprise the infrastructure costs to host a specific software-based service whereas variable costs account for the the load that is requested by customers. Variable costs change based on the demand by customers.

A shortcoming of break-even analysis is that it assumes that variable costs are constant. However, due to inflation, the latter will typically incrase over time. Also, one-time costs such as marketing campaigns typically cannot be accounted for adequately.

Demand-oriented pricing

Demand-oriented pricing has its name from the demand curve that used for deriving a suitable price for a product or service being offered. In competitive markets, price may be used as a strategic advantage to acquire and maintain a specific market share. In markets with few dominant players, the price range can vary only very little.

Value-based pricing

Value-based pricing focuses on the quantified value deliverd to and perceived by the customer / user.

The goal of the price definition process is to maximize the price that the customer is willing to pay for a product or service.

The approach requires several steps such as

  1. Value identification
  2. Value quantification
  3. Value (or sales) argumentation

For the latter, competitor cost as well as switching cost have to be considered as well.

This approach works well in B2B markets for companies that want to position themselves as market or profit leaders.

Comparison and Summary

While cost-oriented pricing is easier to implement, value-based pricing leads to higher margins and better profitability. Successful businesses that apply value-based pricing can also escape competition where price is the only distinguishing factor.

Approach Cost-oriented pricing Break-even analysis Demand-oriented pricing Value-based pricing
Description Requires understanding of internal cost structure Requires separation classification of costs into fixed and variable costs Requires understanding of competition in the market Requires understanding of all benefits perceived by the customer and its users
Pros Relatively easy to implement Relatively easy to implement Price can be used as a strategic instrument to acquire or defend market share Higher margins leading to better profitability.
Cons 1. Low margins 2. Weak sales argumentation (often defending high internal costs) Only concerned about internal costs   Efforts to identify and quantify customer values. Efforts to build up sales argumentation.

References